Product and Marketing Consulting and Services

Pricing – the most important lever

One of the most powerful levers we in product management have for profitability of products is pricing. This may not be intuitive, so an example will illuminate this concept.

First, I will posit that the profit (π) is given by:

π = Q ∗ (P - V) - F

Where Q is the quantity sold, P is the price per unit, V is the variable costs per unit, and F is the fixed cost.

Let’s assume that you have the ability to improve one thing in your operation by one percent. That is you can affect an improvement in variable cost by one percent. Or, you can reduce the fixed costs by 1 percent. Or add 1% additional units to your sales. Or hold the line on pricing by 1%. How does each of these impact the profitability of the business?

Value

last Quarter

Var cost

Fixed Cost

Volume

Price

Price

$25

$25.25

Volume

80,000

80,800

Variable Cost

$10

$9.90

Fixed Cost

$1,000,000

$990,000

Profitability

$200,000

$208,000

$210,000

$212,000

$220,000

Δ Profit

$8,000

$10,000

$12,000

$20,000

% improve

4%

5%

6%

8%

As we can see, the “bang for the buck” goes to improving the price realized, all other items considered equal. Clearly, as this simple sensitivity analysis shows, pricing is essential to unlock value in your business.

Of course, this is a very simple analysis, but it is accurate for all situations. The easiest way to improve profitability is to set the proper price, that doesn’t negatively impact the elasticity, and not leave money on the table.

This is easier said than done, but there are a lot of resources to help you understand the effects of various pricing strategies, how to measure or intuit your price elasticity, and to set pricing bands that will guide your decision process. In future blog posts, I will discuss strategies to both measure important metrics to assist in the setting of prices, tie pricing to market segments and your corporate strategy, and finally, how to identify areas for improvement. Additionally, I will explore the concept of fencing to help isolate market segments by their willingness to pay, and how to price effectively, while minimizing fence hopping.

This multipart journey is just beginning. Hope you stay with us for the ride!

Note: This example taken from “Pricing Strategy” by Tim J. Smith. I highly recommend this book for your shelf.